Curb Your Enthusiasm

After months of steadily rising markets, it's amusing that investors need a 400-point drop in the Dow to remember that sometimes stock prices do, in fact, fall. But in some people's eyes, the scariest thing about Tuesday's big market move wasn't the magnitude of the fall, but a computer glitch that apparently prevented some trades from being immediately reflected in the Dow. When Dow Jones(NYSE:DJ) switched to a backup system to gather current prices, the markets fell sharply in just a few minutes, feeding investors' anxiety that frantic trading activity was pushing the infrastructure of U.S. markets to the breaking point.

In part, the possibility of panic, and its effect on brokerage firms' and traders' ability to deal with spikes in volume, justified the creation of provisions to restrict trading when markets fall below a certain level. Yet these provisions, also known as circuit breakers or trading curbs, remind us how far this market has come since they were introduced in the aftermath of the 1987 stock market crash.

Trading restrictionsThere are several different types of restrictions. One variety, often referred to as trading curbs or collars, requires only a relatively small move of about 2%. It attempts to decrease volatility by limiting program trading, which is often conducted automatically by large financial institutions in response to falling prices of stock index futures contracts.

Circuit breakers, on the other hand, only come into play with large market moves. The number of points it takes for circuit breakers to become effective is based on the level of the Dow, and adjusted quarterly. While 400 points is a big drop, it would currently take a 1,250-point fall just to activate the first of the circuit breakers, which calls for a one-hour halt in trading unless the drop happens toward the end of the day. It takes a drop of 2,500 points to close trading, provided it occurs after 2 p.m., and 3,750 points to stop the day's trading regardless of when in the session it occurs.

Do circuit breakers work?For the most part, circuit breakers haven't really been tested. To date, they've only taken effect once, in 1997. With the Dow having risen so sharply since then, the magnitude of the moves necessary for trading halts to take effect has increased substantially in terms of Dow points. While some argue that breaks in trading allow investors to react less emotionally to market drops, others believe that they merely delay the inevitable.

It's important to realize, however, that just like many protective measures, the benefits of circuit breakers are largely unseen. If the mere existence of circuit breakers and other trading restrictions helps to dampen market volatility, all investors benefit. Furthermore, circuit breakers were developed in part to promote investor confidence, the benefit of giving exchange traders and brokerage-firm employees a chance to organize order flow and trade settlement would be extremely valuable, especially given the reaction many investors might have to a 10% single-day drop in the markets. Although brokerages didn't report any significant trading problems Tuesday, a more severe downturn might create greater volumes of orders to manage.

If market volatility continues, you're likely to hear a lot about circuit breakers in the coming months. The prospect of market closures can alarm even the most rational investor, but trading restrictions can help make those markets more efficient and orderly for everyone.

Author

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.
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